Although APY and APR are similar acronyms, they serve very different purposes in the financial world. Whether borrowing, lending, spending, or saving, it’s essential to understand what each metric measures and how they work. Knowledge is power, and in this case, it will give you a better understanding of what’s happening with your money.
Key Findings:
- APR and APY are both metrics used to measure interest but take into account different factors.
- APR is generally used to make loans look less expensive, while APY ensures an investment looks as enticing as possible.
- Whether borrowing or investing, understanding the clarity APR and APY offer, along with their limitations, can help you seek better terms.
What is APR?
APR stands for annual percentage rate, and it helps a borrower understand what they’ll be paying in interest and fees on borrowed money.
APR takes fees into account when measuring interest. It can be used to indicate earnings as well as costs, though it is much more frequently used by lenders when presenting loan terms. While it doesn’t take compounding interest into account like EAR (effective annual interest rate - a topic for another time 😉) does, it offers more clarity on potential earned gains than simple interest alone.
What is APY?
APY stands for annual percentage yield. APY is the metric used whenever interest is being accrued through deposit accounts like a savings account or an investment fund. It is an annualized expression of how much your investment will earn.
APY is different from simple interest because it takes into account the effects of compound interest. Compound interest refers to the amount of interest that grows and earns more interest over time. It’s commonly associated with a deposit account, personal loan, or investment opportunity and gives the amount invested (the principal) an opportunity to increase exponentially over time rather than linearly.
The difference between APR and APY
While they may sound similar, APR and APY are two very different approaches to measuring interest.
APR combines simple interest and fees on a credit card or loan to help a borrower better understand the cost of borrowing money. While it can also be used to measure return on investment, it is not as favorable for this purpose as APY—so it is generally a one-trick pony.
APY, on the other hand, factors in compounding interest on savings accounts or investments to help an investor more accurately forecast their money’s growth potential.
Additionally, APR interest compounds differently than APY, as APY helps you to track how compound interest grows over time.
APR takes into account:
✅ Interest rate
✅ Fees
✅ Miscellaneous loan costs
❌ Compounding interest
While APY takes into account:
✅ Interest rate
❌ Fees
❌ Miscellaneous loan costs
✅ Compounding interest
Accounts with APR vs. APY
APR and APY highlight different costs and potential gains. This is why most financial products’ only refer to one metric. Generally speaking, APR is used when borrowing money, while APY is more relevant when investing—although this is not universally true.
Financial products can be categorized in many different ways. One is to separate them by those that disclose APR and those that advertise APY.
APR is used with:
- Credit Cards
- Mortgages
- Any other types of loans (e.g. student loans, car loans, etc.)
APY, on the other hand, is used with:
- Savings accounts
- Money market accounts
- CDs (certificates of deposit)
- Investment funds (e.g., mutual funds, ETFs, etc.)
Why it’s important to understand APR and APY
Without a clear understanding of both APR and APY, you may be missing opportunities to earn additional interest or spending more on fees than you realized. Understanding how to break down a loan’s repayment model or calculate an investment's potential growth can help you make better informed financial decisions.
APR is useful when you’re borrowing money and comparing rates. The lower the APR of a loan, the less total interest you’ll have to repay. Especially with large loans like home loans, even a very small difference in APR can make a huge difference in the amount you pay over time.
It’s just as important to understand APY so you can compare and contrast different yields. By putting your money into an account with a higher APY, you stand to make significantly more money—especially if you plan on using that account long-term. Just keep in mind that accounts with higher APYs may come with greater investment risk or limited access to the funds.
In essence, understanding APR and APY will help you to save more when borrowing and earn more when investing.
How to calculate APR and APY
Knowing how to calculate both APR and APY is valuable. The following formulas may not make for great party tricks, but they do work wonders for selecting the right bank accounts and loan options.
The formula for APR is:
((Interest + fees) / loan amount) / number of days in the term x 365 x 100 = APR
Let’s say we have a loan with a principal balance of $1,000. It’s a fixed-term loan for one year, with a 20% interest rate, so we know $200 in interest will be paid over the life of the loan. Most loans you receive from lenders charge an origination fee, so let’s also add that to our example - an origination fee totaling $20.
By plugging the numbers into the above formula, we get:
((200 + 20) / 1000) / 365 x 365 x 100 = 22%
So, in this example, the APR would be 22%, with 20% coming from interest, and 2% coming from fees. The total amount owed on this loan would be $1,220.
In the following formula for determining APY, ‘r’ is the stated interest rate and ‘n’ is the number of compounding periods per year:
(1 + r / n ) ^ n – 1 = APY
Once again, let’s plug some numbers into the formula. If the stated annual rate is 5% (represented as 0.05) and there are 12 compounding periods in a year, we get:
(1 + 0.05 / 12 ) ^ 12 - 1 = .0512 * 100 = 5.12%
When comparing investment opportunities, consider the frequency of compounding. In this example, because the interest is being compounded monthly, the APY works out to be 5.12%. Had the interest been compounded annually the APY would have been slightly lower, and had it been compounded daily, the APY would have been slightly higher. You get the gist 🙌
EAR vs APR
EAR (effective annual rate) is another crucial interest rate metric to understand. While APR offers more insight into how much borrowing might cost (since it includes fees and other costs), EAR considers the compounding interest that comes with carrying a balance as well.
APR is based on simple interest, and you might see it being used to compare mortgage and auto loans. EAR is most effective for evaluating accounts that frequently compound, such as credit cards, so you will usually see APR and EAR used in different scenarios.
What is a good APR for a credit card?
One of the most common uses for APR is credit card interest. Since 70% of American adults have at least one credit card, it’s especially important to understand how this works.
At the time of this writing, the average credit card APR hit a record high in November of 2022 at 19.04%. As you consider credit card offers, a good APR could be described as any line of credit with a lower rate of interest than 19.04%. For some, however, it may be more prudent to research what the lowest APR may be based on their credit score (especially if it’s in the lower range).
While finding the lowest APR possible is ideal, consider other fees associated with the card as well. A loan’s APR includes both interest and fees, credit card APR only refers to interest.
You should also make note of future APRs. Many credit card companies offer cards with introductory rates at 0% APR. Always do your research when comparing credit cards. While APR is a helpful metric, it’s not the only factor to consider.
What is a good APY for savings accounts?
A savings account offers a low-risk approach to earning interest. It’s one of the most common financial products advertised with APY.
The average APY for an American-based savings accounts is 0.33% (as of Feb 2023). So when it comes to finding a savings account with a good APY, search for anything over the national average.
However, if you can meet the deposit requirements and handle fluctuating interest rates, there are plenty of high-yield savings accounts that offer well over 2% APY.
There are some potential downsides to high-yield savings accounts, though. They can have hefty fees that may offset some or all earned interest. Also, high-yield savings accounts tend to return less than most investment funds. So if you have a higher risk tolerance, and want to invest your money as opposed to stashing it away, exploring an investment fund might be the way to go instead.
Bottom Line: APR vs. APY
Although APR and APY sound and look similar, they are two very different terms. They’re equally important acronyms for anyone who borrows, saves, or invests (aka everyone) to understand.
Financial institutions advertise APR rates to make a loan or credit card seem more appealing to a borrower. However, they often disguise the true cost of borrowing by leaving out the effect of compounding interest. While they can provide guidance as to which borrowing option is the most affordable, an APR shouldn’t be the end-all metric for borrowers to consider.
APYs give a better idea of an investment’s rate of return and can help investors find a balance between risk and reward. But because APYs can be fixed or variable, they’re far from a guarantee.
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